MASENO UNIVERSITY

AUDITING 1
BFA 312

ASSIGNMENT
LECTURER: DR GEORGE OBOP
GROUP MEMBERS

1.simon mutua BAF/00116/020

2. Simon Neparju BAF/00144/020

3. Janet Rose BAF/00037/020

4. Yussuf Hassan BAF/00119/020

5. Moses Kamande BAF/00001/020

6. Douren Nafula BAF/00136/020

7. Francis Mwangi BAF/00043/020

8. Linet Mwangi BAF/00096/020

9.Lornah Umazi BAF/00060/020

10.Leparan Wilfred BFA/00141/020

11.GILBERT RONOH BAF/00104/020

QUESTION ONE: (15 MARKS)

(a) State and explain the circumstances in which an auditor may give a qualified audit
report.(5 Marks)

i. When the financial statements are materially misstated due to misstatement in one
particular account balance, class of transactions or disclosure that does not have
pervasive effect on the financial statements.
ii. When the auditor is unable to obtain audit evidence regarding particular account
balance, class of transactions or disclosure that does not have pervasive effect on
the financial statements.

(b)State and explain the type of opinion that should be expressed in the auditor’s report
in each of the following situations:

i. A debtor owing a large amount of money is unable to pay a client company and the
directors have not made an allowance for bad and doubtful debts. (3 Marks)
The modified opinion is formed when the company’s financial statements are prepared
according to accounting standards and are in all material respect. It is a type of opinion that
is expressed if the auditor has gathered enough and correct evidence from the company’s
books of accounts and thus in this case the auditor will give an unmodified opinion as the
allowance for the bad debts has not been catered for according to the accounting
standards.

ii. A client company has changed its accounting policy during the current financial year and
there is no retrospective adjustment. (3 Marks)
An adverse opinion specifies an extremely suspicious accounting statement that can
diminish the company’s market position, sometimes causing a lawsuit. Auditors who spot
extensive material misstatements and are fully dissatisfied with the accounting statements
have to present such a viewpoint. The high level of misrepresentation may also result in
fraudulent activities. Needlessly, financers and investor’s view this as a red flag avoiding any
commercial activity with the audited entity. Change in accounting policy may lead to
changes in the financial statement which were not reflected, this will be against the
accounting standards and it may also alter the financial statement giving a force
presentation of the business.

iii. There is disagreement over treatment of a material amounts in the accounts (4 Marks)
An adverse opinion specifies an extremely suspicious accounting statement that can
diminish the company’s market position, sometimes causing a lawsuit. Auditors who spot
extensive material misstatements and are fully dissatisfied with the accounting statements
have to present such a viewpoint. The high level of misrepresentation may also result in
fraudulent activities. Needlessly, financers and investor’s view this as a red flag avoiding any
commercial activity with the audited entity. Therefore, the auditor will give an adverse
opinion over this situation as over treatment of a material amounts in the accounts posses a
great risk to the company and to the investors also.

QUESTION TWO: (15 MARKS)

i. Describe the various procedures of obtaining audit evidence giving an example of

each (6 Marks)
1. Inspection
The inspection involves examining records or documents, whether internal or external,
in paper form, electronic form, or other media, or a physical examination of an asset.
Inspection of records and documents provides audit evidence of varying degrees of
reliability, depending on their nature and source and, in the case of internal records
and documents, on the effectiveness of the controls over their production. An example
of inspection used as a test of controls is the inspection of records for evidence of
authorization.

2. Observation
Observation consists of looking at a process or procedure performed by others, for
example, the auditor’s observation of inventory counting by the entity’s personnel or
the performance of control activities. Observation provides audit evidence about the
performance of a process or procedure. Still, it is limited to the point in time at which
the observation takes place and by the fact that the act of being observed may affect
how the process or procedure is performed.

3. External Confirmation
An external confirmation represents audit evidence obtained by the auditor as a direct
written response to the auditor from a third party (the confirming party), in paper form,
or by electronic or another medium. External confirmation procedures frequently are
relevant when addressing assertions associated with certain account balances and their
elements.

4. Documentation
Documentation is the auditor’s examination of the client’s documents and records to
substantive the information that is or should be included in the financial statements
The documents examined by the auditor are the records the client uses to provide
information for conducting its business in an organized manner. Because each
transaction in the client’s organization is normally supported by at least one document,
there is a large volume of this type of evidence available.

5. Recalculation
 Recalculation consists of checking the mathematical accuracy of documents or records.
Recalculation may be performed manually or electronically.

6. Reperformance
Reperformance involves the auditor’s independent execution of procedures or controls
originally performed as part of the entity’s internal control.

7. Analytical Procedures
Analytical procedures evaluate financial information by analyzing plausible
relationships among financial and non-financial data. Analytical procedures also
encompass such investigation as is necessary for identifying fluctuations or
relationships that are inconsistent with other relevant information or differ from
expected values by a significant amount.

8. Inquiry
Inquiry consists of seeking information from knowledgeable persons, both financial and
non-financial, within or outside the entity. An inquiry is used extensively throughout
the audit and other audit procedures. Inquiries may range from formal written inquiries
to informal oral inquiries. Evaluating responses to inquiries is an integral part of the
inquiry process.

b) Discuss the auditor’s responsibilities with regards to the detection and prevention of
frauds and errors. (2 Marks)

Auditor don't have any responsibility for detection of frauds and errors. It’s the
management responsibility. Auditor responsibility is just to provide independent opinion
over the true and fair view of financial statements. But during Audit, if auditor detect any
fraud or error, it should be communicated to management.

ii. State what actions an auditor would take if the director refused to provide him with a
letter of representation (4 Marks)
i. The auditor should provide a disclaimer of opinion as these representations
effectively underpin the audit as a whole.
ii. The auditor would evaluate any reliance placed on other representations made by
management during the course of the audit and consider if the other implications of
the refusal may any additional effect on the audit report.

(d)Outline the benefits that can be derived by an audit from the successful employment of
statistical sampling techniques as opposed to non-statistical sampling. (3 Marks)

(1) design an efficient sample,

(2) measure the sufficiency of evidence obtained

(3) quantify sampling risk

QUESTION THREE: (15 MARKS)

Threats to independence of an auditor can broadly be categorized into 5 types.

(a) Identify these threats and give examples (5 Marks)
1. Self-Interest Threat: A self-interest threat exists if the auditor holds a direct or indirect
financial interest in the company or depends on the client for a major fee that is
outstanding.
Example
The audit team is preparing to conduct its 2022 audit for SARIKA Company. However, the
audit team has not received its audit fees from SIRIKA Company for its 2021 audit.
2. Self-Review Threat
A self-review threat exists if the auditor is auditing his own work or work that is done by
others in the same firm.
Example
The auditor prepares the financial statements for MAGA Company while also serving as the
auditor for MAGA Company.
3. Advocacy Threat
An advocacy threat exists if the auditor is involved in promoting the client, to the point
where their objectivity is potentially compromised.
Example
The auditor is assisting in selling WEMA Company while also serving as the auditor for the
company.
4. Familiarity Threat
A familiarity threat exists if the auditor is too personally close to or familiar with employees,
officers, or directors of the client company.
Example
ZENTA Company has been audited by the same auditor for over 20 years and the auditor
regularly plays golf with the CEO and CFO of ZENTA Company.
5. Intimidation Threat
An intimidation threat exists if the auditor is intimidated by management or its directors to
the point that they are deterred from acting objectively.
Example
MKIKI Company is unhappy with the conclusion of the audit report and threatens to switch
auditors next year. MKIKI Company is the biggest client of the auditor.

(b) Using examples outline the possible safeguards that an auditor can apply against these
threats. (5 Marks)

Self-interest threat
It arises when an auditor acts in her own financial or other personal self-interest. It happens
in an audit engagement when the audit firm, its partners or team members benefits
materially from a financial or other interest in an audit client. For instance, a member of the
audit firm might hold shares of a company and discover an irregularity in its financial
statement. If she believes that such disclosure will result in a fall in its share price and
thereby affect her net worth, she might refrain from making such disclosures.
Ways to deal with self-interest threats.
i. by ensuring such members (holding shares, for instance) leaves the team or at least
disposes of the shares before an engagement.
ii. If the above is not applicable consider leaving the engagement altogether.
Intimidation threat
It arises when an auditor is being overtly or covertly coerced by an audit client or by another
interested party. The client is also aware of this and threatens to discontinue the audit
services if it discloses any financial irregularities.
Auditors can avoid being intimidated by
i. By doing a thorough background check of new companies before making a pitch,
such difficult engagements can be avoided.
Familiarity threat
Long-time association of the auditors with the client, for instance, can create familiarity and
the auditor might become sympathetic towards their actions. It could cloud objectivity and
ultimately the quality of the audit report.
The Company Law to some extent addresses this issue by stipulating that no company can
appoint an audit firm as an auditor for more than two terms of five consecutive years.
How to deal with familiarity threat
At the auditor level, if an audit member has any family or personal relationship with an
employee of the client, either he should be removed from the team or audit engagement
structured in a way so that they don’t deal directly.
Self-review threat
It refers to the threat of bias arising when an auditor audits his own work or that of his
colleague. This typically happens when the auditor has provided other services other than
that of audit and review of financial statements to the same client.
Self-review threat can be avoided by
i. Having separate teams for audit and other services. If that is not possible, consider
relinquishing the engagement.
Advocacy threat
It arises when an auditor also acts as an advocate for (or against) an audit client’s position or
opinion by representing them. For example, a company might hire its auditor to represent
them in court for a dispute with a buyer. In this circumstance, the auditor is an advocate for
the client and therefore might refrain from disclosing financial misstatements.
Auditors can safeguard against this threat by
 i. Segregating their team for each task or by choosing between representing or audit
engagement

iii. Outline the factors that an auditor will consider prior to accepting re-appointment. (5
Marks)
i. The audit firm’s standard billing rates for classes of professional personnel for each of
the last three years.
ii. The audit firm’s staff turnover experience in the last three years as well as other quality
control systems. i.e. How will it ensure staff continuity on the company’s audit?
iii. The amount of attention the audit firm is given by the company.
iv. The audit firm’s reputation (including outcome of recent firm inspections or other
regulatory oversight reviews, if available).
v. How the audit firm resolves technical disagreements
(a) among engagement personnel and
(b) between the firm and the client.
vi. Whether or not the audit firm complies with the requirement for audit partner rotation
every five years.
vii. The audit firm's representation and network in other jurisdictions that the company or
a group it has operations in.
viii. How the audit firm co-ordinates with its counterparts in other jurisdictions for audits
involving multiple jurisdictions

QUESTION FOUR: (15 MARKS)

Machio Ltd. is an import and export company located in Nairobi. The company deals in the
importation and exportation of various goods for direct sales to retailers on both credit
and cash terms.
You are employed as an audit Manager by Wabwanga & Company Auditors currently
engaged in the statutory audit of the company’s books.
Required:
(a) Describe the main internal controls that you would expect to find in operation
with regard to the company’s sales and receivables. (6 Marks)
i. Arithmetic and accounting control. These are controls that ensure
transactions are authorized, recorded correctly, and accurately. This ensures
that the transaction is complete and accurate. The Machio ltd sales
department stated that they lacked this arithmetic control, which is why they
received cash directly from the salesmen over the counter. If there is a
situation where salesmen give over the counter while others pay through the
mail, the cash received from the sales department may not be the correct
figures.
ii. Segregation of duties. This refers to the separation of various duties and
responsibilities to the point where one person cannot process and record
complete transactions from start to finish without being double-checked by
 another. In the case of the Machio ltd, it is clear that no one double-checked
the accountant's work in the sales department. It was not proper for the
sales department to receive money directly from the salesmen. As a result,
the Machio ltd sales department lacked more personnel to double-check
each other's work.
iii. Physical controls. These are asset-custody security measures that restrict
access to only authorized individuals. Only authorised individuals have access
to valuable assets. Following an audit of Machio ltd, you will discover asset
restrictions in the sales department. To avoid contradictions, cash collection
will be done by specific people in a specific way. This can be accomplished by
installing security cameras or locking the accounts office.
iv. Personnel. Any system's ability to function depends on the competence and
integrity of those who operate it. Machio ltd must hire competent and
trustworthy employees. Staff should be assigned responsibilities based on
their abilities and receive training to ensure that work is completed correctly.
Working staff in the Machio ltd sales department are expected to be well-
trained and knowledgeable about the work they are doing.
v. Supervision. The day-to-day operations should be supervised by competent
and responsible officials. The head of Machio ltd's sales department is
responsible for overseeing the work of all sales department employees.
Officials must ensure that the salesmen are following the rules.
vi. Routine and automatic checks. These are tests carried out on routine tasks
and operations to ensure that they are running smoothly. To prevent fraud,
such checks are carried out as a surprise. Physical inspection and cash counts
are two examples. You can expect regular checks in the Machio ltd sales
department to ensure that the right thing is done.
(b)Briefly explain the inherent limitations that might hinder the effective operation of an
internal control system over sales and receivables in Machio Ltd (4 Marks)

1. Judgment: The effectiveness of controls will be limited by decisions made with human

judgment under pressures to conduct business based on the information at hand.

2. Breakdowns: Even well-designed internal controls can break down.  Employees

sometimes misunderstand instructions or simply make mistakes.  Errors may also result

from new technology and the complexity of computerized information systems.

3. Management Override: High level personnel may be able to override prescribed policies

and procedures for personal gain or advantage.  This should not be confused with
 management intervention, which represents management actions to depart from

prescribed policies and procedures for legitimate purposes.

4. Collusion: Control systems can be circumvented by employee collusion.  Individuals

acting collectively can alter financial data or other management information in a manner

that cannot be identified by control systems

(c) Audit risk is the product of Inherent Risk, Control Risk and Detection Risk.
I. Define Inherent Risk, Control Risk and Detection Risk (2 Marks)
a) The inherent risk could not be prevented due to uncontrollable factors, and it is also
not found in the Audit.
b) Control Risk is the risk of error or misstatement in financial statements due to the
failure of internal controls
c) Detection risk is the risk of failure on the auditor’s part to detect any errors or
misstatements in financial statements, thereby giving an incorrect opinion about the
firm’s financial statements.
II. Discuss these in the context of Machio Ltd sales and receivables. (3 Marks)
i. Inherent risk; transactions of the company involving high-value cash amount carry
more inherent risk than transaction involving high-value cheques.
ii. Control risk; failure on the part of management to control and prevent transaction carried
out by staff who is not authorized to carry out those transactions in the first place of the
company.
iii. Detection risk; Failure by Auditors to identify the company’s continuous misreporting of
financial statements.